Motley Fool personal finance expert Robert Brokamp recently caught up with William Bernstein to discuss topics including:
- Why a 2% real return is “quite spectacular.”
- The math and Shakespeare of investing.
- Why value stocks may have fallen out of fashion.
- What the history of the stock market reveals about modern bubbles.
To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
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This video was recorded on Sep. 10, 2023
William Bernstein: It’s also how the rich get richer. If you have enough safe assets, if you have enough treasury bills to live on for three years, or five years, or better yet, a decade. You’re not going to panic when the rest of your holdings, the risky asset, the stocks that you own, fall by 50%, 60% You’re not going to pull the trigger and sell those at the bottom.
Mary Long: I’m Mary Long, and that’s William Bernstein, financial theorist, neurologist and best-selling author. Our very own Robert Brokamp caught up with Bernstein to talk about the psychology of investing in the weighty influence of crowds. How to test a financial advisor the best deal in retirement planning. What’s changed in the two decades since Bernstein first wrote the investing classic, the four pillars of investing, lessons for building a winning portfolio.
Robert Brokamp: The Motley Fool was founded in 1993 by two brothers and their friend who believed that with enough effort and dedication, most people could learn to manage their finances on their own, and they might be better off for doing so, given how poorly Wall Street and the typical local stockbroker often treated the individual investor. It occurred to me that around the same time, maybe a few years earlier, your life was taking a similar turn. You were a practicing neurologist who was just beginning what would become a whole new career as an author of several well respected books about investing in financial history, as well as becoming the principal in a wealth advisory firm. So tell us how that career switch happened.
William Bernstein: Well, around that time. A generation ago, I realized that I lived in a country that didn’t have a functioning social welfare system and safety net and that I was going to have to save and invest on my own. I approached that the way that I thought that any person with scientific training would do, which is that I built models, I collected data. When I was done doing that, I realized that I had actually done something that was useful to the small investor. Because 30 years ago, those tools simply weren’t available to small investors. Now they’re available with the click of a mouse. But back then they weren’t. I discovered that I enjoyed writing. About that time, the web connected to my rural place of residence and I threw some of this stuff onto the web and people responded to it and that’s how I got my career as a financial writer and then a historical writer on top of that, because you can’t write about finance without writing about the history of finance.
Robert Brokamp: Yeah and that, in fact, is one of the four pillars of your book, The Four Pillars of Investing. Originally published in 2002. Now 21 years later you’ve published an updated version of the four pillars. What would you say are the biggest differences between the first and second editions?
William Bernstein: Three things in the first place. I have slowly come to understand over the past 30 years that the mathematical models only take you so far, and in fact, they can fool you. The financial markets some people would like to believe behave like an electrical circuit or an airfoil. The more math you know, and the more you depend upon the math, the better off you’ll be. In fact, beyond a certain point, the opposite is true. People, it turns out, can focus too much on the math and not focus on the other half of investing, which is the Shakespeare of investing. All you have to think about to realize that problem, or to see that problem is the history of long term capital management, which is what happens to you when you’re really good at the math and you’re not really good at the Shakespeare. That’s the first thing. The second thing was taking to heart Charlie Munger’s dictum of compounding. Which is that, yes, compounding is magic, but that the prime rule of compounding is never ever to interrupt it.
The time when you’re most likely to interrupt the compounding is in the worst 2% of the states of the world during financial panics, when all of the things that you thought were solid beneath your feet crumble. The second thing that I’ve learned over the past 20 or 30 years is that if you’re going to have an investment policy and investment strategy, you have to design it to survive those times. It has to be a good deal more conservative than you think that otherwise would be. The third thing that’s changed over the past 20 or 30 years, and this is something that’s happened really very rapidly over the past 10 years, is that you can invest competently in almost any institution. The advice that I gave in the first edition of the book was to stay as far away as you could from the full service brokerage houses, the Merrill Lynch and the Morgan Stanley‘s of this world. Well, it turns out that you can put together a perfectly good investment portfolio with those institutions simply by using exchange-traded funds and keeping your expenses to a minimum. You know in the first edition of the book, I was accused of being a shell for the Vanguard Group because that was really the only place that you could get rock bottom expenses. Well, now you can get rock bottom near zero expenses almost anywhere, at almost any institution. If you’re careful, there’s no reason why you can’t have an account at one of the big bad, old warehouses, let alone, Schwab or Fidelity, which you’re just fine too.
Robert Brokamp: You’ve touched on a few key components of the four pillars. Let’s dig a little bit more into each of them. Pillar 1 is investment theory, you touched on a little bit really being aware of your risk tolerance. I think really your key principle is probably could be summed up with two of my favorite lines from your book. One is the essence of investing is not maximizing returns, but rather maximizing odds of success and the other is the aim of retirement saving investing is not to get rich, but to minimize the risk of becoming poor.
William Bernstein: Yeah, that’s the first pillar, which is the connection between risk and return. You can’t expect high returns. The high returns do you get with stocks without seeing your portfolio take a serious haircut every now and then. There’s no way of avoiding that because there’s no way that anybody can time the market. Then if you want perfect safety, you’re going to have to be satisfied with low returns. Now right now, you can get perfect safety in retirement or as near as perfect safety as you can get by investing in a ladder, for example, of treasury inflation protected securities. You can get a 2% real return, which historically is actually doesn’t sound like very much, but it’s quite spectacular because a 2% real return gives you a 30 year success rate with a withdrawal of nearly 4.5% which is as good as you can expect. That’s the first pillar is realizing the connection between risk and return and also understanding how to put together portfolios in a prudent manner.
Robert Brokamp: Another point that you emphasize is that part of the theory is developing expected returns from your portfolio, helps with retirement planning and other things like that. How do you think people should do that and what do you see as reasonable expectations from stocks and bonds nowadays?
William Bernstein: Well, the expectation is of 2% real returns from bonds. By the way, I tend to throw that around a bit too glibly when I say real returns, I mean after inflation. A 2% return after inflation may not seem like very much, but that’s historically what bonds have returned in the past. Anytime you can get the historical rate of return, you should grab it. As recently as two years ago, you were lucky to get even a negative 1% return on intermediate term. Bonds a real return that is to say after inflation, so that’s pretty darn good. Now, you can also expect probably three or 4% on top of that from investing in stocks, but in order to get that return, it doesn’t come for free. You’re going to have to pay for that with a lot of stomach acid from time to time. One of the third pillar of the book is the psychological pillar. One of the fundamentals of psychology is that we tend to be very overconfident. We’re over confident about our ability to pick securities, we’re over confident about our ability to pick successful money managers, but the importance of those fades into in significance when compared to the overconfidence about our ability to tolerate risk. When the sun is shining everybody is a long term investor in stocks, but when the clouds turn dark people behave a lot differently and as that financial economist Michael Tyson famously said, everybody’s got a plan until they get punched in the mouth.
Robert Brokamp: Just to be clear that 3-4% from stocks is inflation adjusted so you would take. If inflation is 3% you’re looking at 6-7% which is below the historical average, why do you expect below average returns from stocks?
William Bernstein: Let me back up a second because there’s a couple of building blocks there that need to be unpacked. First of all, you’re going to get a rare 2% real return from bonds, you should expect to get a three or 4% premium on top of that so as you said, 5 or 6% but that’s a 5 or 6% real return if you add inflation and on a nominal basis it’s closer to 10%. Now, that’s not as high as you’ve gotten historically, and the reason why is very simple is that everybody talks about returns since 1926, and that’s when the CRSP and bits and basis in set. But the problem is that over that past almost a century, that the dividend yield has fallen by a factor of four, price earnings have fallen by a factor of two or three. You’ve gotten a real boost from that change in valuation, and the only way you’re going to get that historical return is if valuations continue to increase. That means that in another century we’ll be looking at normal PEs of 60 dividend yields of a 0.5%, that’s not going to happen.
Robert Brokamp: It’s certainly makes sense. Go ahead.
William Bernstein: At least I don’t think it’s going to happen but it could, but I wouldn’t bet the farm on it, that’s for sure.
Robert Brokamp: That gets to my point, and that is if you’re thinking of what’s my portfolio going to provide so I can plan for retirement. It makes sense to assume lowered returns. You want to assume lower returns, you don’t want your retirement riding on hoped for extraordinary turns because then you’ll reach your ’60s and maybe haven’t saved enough.
William Bernstein: Exactly, the real question is how much risk are you going to take. If you assume those returns, that’s by the way the median expectation, but that means there’s a 50% chance you’ll get below that expectation and there’s a five or 10% chance you may get four or 5% under that expectation, because that’s just the nature of the statistics of stock returns.
Robert Brokamp: Now, let’s move on to the second pillar and that is the history of investing. You wrote that bubbles and bus are inevitable features of financial markets ever since the 17th century. Tell us what a bunch of Englishmen from the 1600 specifically goldsmith and Francis Bacon, have to do with why we continue to have these occasional wild swings in the stock market.
William Bernstein: Well, it all goes back to the history of the East India Company and its individual predecessors. You had these guys coming back from the far East with enormous piles of silver and gold, and even jewels with the profits from their trading operations, from dealing with fine spices and porcelains and things like that and they would arrive in London with all of this loot and London at that point didn’t have a banking system. Remember, this was England even before the Civil War in the 17th century. They needed a safe place to keep all of this loot, and the people who knew how to do that, to keep very precious things safe, were goldsmiths. They would give their lot to these goldsmiths, and the goldsmiths would give them a certificate and the certificates actually started trading as money. Then it occurred to the goldsmiths, hey wait a minute, we can loan these certificates out at an enormous rate of interest 10%,15%. They didn’t have to if they had 10,000 pounds worth of silver or 10,000 pounds of silver, which is how we get pound sterling in their safes or whatever they used for safes back then, they could print 30, 20 or $30,000 worth of certificates and earn an enormous amount of interest. The only problem occurring, of course, was that if somebody they only had 10,000 pounds in their safe and people bearing certificates for 10,001 pounds came in, they were bankrupt, that was a bank run. This system where you have certificates or the money that they could basically print circulating in excess of the reserves is called the Fractional Reserve System, which we have yet today. We don’t run on a two or 3:1 ratio, now banks run on about a 10:1 ratio, and it’s an inherently unstable system. You see, bank runs from time to time, has occurred with Silicon Valley Bank and has occurred more disastrously with the Northern Trust in England several years ago. This is a system that is prone to booms and busts, which play through to the stock market.
Robert Brokamp: Then in 1621, I believe Francis Bacon published a book, many consider it’s the beginning of the scientific method, how has that contributed to booms and busts?
William Bernstein: Well, because when you have a scientific method, you can invent marvelous technologies. When you have a good model of the world, suddenly within a century or two, you have thermodynamics, you have electromagnetic theory and you get the internal combustion engine and the telegraph and the radio. If you want to know where stock returns come from, it comes from the invention of things like that. That’s how the economy grows and that’s how stocks become the place to be because stocks accrue the earnings from the profits of all of these marvelous inventions. Without Bacon scientific method, without the Nova Organum, which was the book that he published that described it, we wouldn’t have any of the marvelous things that we have now. We’d be living the same way that people lived 400 years ago, which wasn’t a very good place to be.
Robert Brokamp: Of course, these are all wonderful things, but they often lead to some a boom. Whether it was the.com boom, whether it was as you’ve written about in previous books, the railroad boom or it could be financial technologies. Collateralized loan obligations from the Great Recession of 2007-2009, part of it is what causes the booms and busts.
William Bernstein: Exactly. The first person to really cotton onto this in an intuitive sense was a man by the name of Heyman Minsky, who was an economist who lived a generation or two ago. He formulated something called the Instability Hypothesis, Which means that when people’s animal spirits are optimistic, banks loan money and gradually they loan money in riskier and riskier fashion and then eventually collapse. You get a bust, like we saw, for example, in the housing crisis in 2007-2009. Then all of a sudden bankers and investors get religion, they become a lot more conservative. Loans start becoming much safer. Then people realize that by taking more risk, they can earn higher and higher returns, and the cycle starts anew. The instability hypothesis states that instability eventually results in stability when things collapse and people get religion about risk. Then stability causes people to eventually start levering up again. Stability causes instability, and instability causes stability. Round and round you go. The cycle seems to last about 10-15 years. If you tabulate all of the booms and busts over the past four centuries, that’s roughly the interval that you see, it’s not liable. You can’t set your watch by it, but that’s about what it looks like.
Robert Brokamp: Let’s move on to pillar 3, The Psychology of Investing. When I think about what has changed since the first publication of the four pillars, I would say that one of the biggest differences is the increased prominence of behavioral finance. You had a couple of side comments in the book about how maybe it’s getting too much attention or maybe just too many people out there holding themselves as experts. But I think your take on the subject can be summed up when you write that the human species is the ape that imitates, tells stories, and seeks status. What do you mean by that, and what’s the impact on how people invest?
William Bernstein: I think the part of behavioral finance that has been under emphasized. It’s not the individual psychology or what gets referred to as the neuropsychology, it’s the social psychology. The seminal experiment that I think that is the way to understand finance was one performed by a guy by the name of Solomon Asch. He put a bunch of people in a room and he had the match line length. It was a relatively simple task that was just difficult enough that you could do it right about 99% of the time. There was a very small error rate. What he found was, is that when he put people into a room where other people were shouting out the wrong answers, the error rate skyrocketed. When people around you are making mistakes, then you are likely to make mistakes too. There’s a very famous example that everyone knows about from Francis Galton. He went to a livestock fair more than a century ago, and he had a bunch of independent observers estimate the weight of a dressed ox. In other words, they showed them the ox, and then they had to guess how much meat basically you could get off the ox. The average guess was very close to the real weight. It was within a pound or two of the actual weight. This thing weighed over 1,000 pounds. A man by the name of Joel Greenblatt, who I think a lot of people in finance will recognize, he’s written a lot of very popular books, did the same experiments with a jar of jelly beans that he showed a class and he put, I believe, 1,776 jelly beans in the glass. This elementary school or middle school class, the average, just like in Galton’s experiment, came within a few jelly beans of what the real answer was. But when he had people, then when he had another class discuss or maybe the same class, I forget which discussed, what their guesses were and people started feeding off of that. Their answer was off by more than 30%. This is what happens when you’re around other people. The best way to invest is to lock yourself in a dark room and don’t talk to anybody. Don’t read the newspaper. Don’t talk to your friends because they’re going to lead you astray.
Robert Brokamp: Let’s move on to pillar Number 4, and that is the business of investing in your book. You tell the tale of a mythical land in Eastern Europe called Cher Novia, where someone could get sick and they go to a doctor and then you find out later that the doctor you didn’t have to go to medical school and doesn’t even have a professional duty to the patients. What’s the comparison there to the world of financial advice?
William Bernstein: Well, it’s very simple to become a stockbroker, you have to pass the series seven exam. It doesn’t say you have to have graduated from high school. That’s the first problem. The second problem is a more general one, which is that people do not go into finance for the same reason that people become elementary school teachers or they become Marines. They go into finance because as Willie Sutton talked about robbing banks, that’s where the money is. The moral and ethical standards of people in finance is not the same as the moral and ethical standards of people who become Marines or elementary school teachers. I’ll leave it at that.
Robert Brokamp: [laughs] I totally understand. It is interesting to me, it’s almost unbelievable really that you can be someone who is giving financial advice, but you are not legally obligated to put their best interests first. What is legally called the fiduciary standard. It’s amazing to me that they get away with it.
William Bernstein: If you’re a registered investment advisor, you do. But if you’re a stockbroker, you basically don’t. FINRA and the [inaudible] have worked on a number of upgrades to what’s called the suitability standard for stockbrokers, but it’s toothless. When you talk to a stockbroker, hold on tight to your wallet.
Robert Brokamp: That’s all true. I generally agree with you, but not everyone has the time or inclination to be their own financial planner and investment advisor. What do you recommend that people do?
William Bernstein: Well, the first thing you should do is ask them, are they willing to sign the fiduciary pledge? Just find it online, download it and ask your financial advisor to sign that. If they’re not willing to sign that or they talk about how irrelevant it is, make a 180-degree back turn and run as fast as you can. That’s the first thing and there’s a little practical task that I recommend people as well, which is bring to them your own little portfolio. Let’s say that you’ve got a three fund portfolio of an index of international stocks, US stocks and an indexed bond fund. Ask them what they think of it. If they look at you and say, I think that’s pretty good. I might add an asset class or two to this. They’re probably OK if they look at you and they say, no, I can beat the market, I can pick stocks, I can pick better money managers than this. That’s another warning sign as well.
Robert Brokamp: Then in your book, you cite a Harvard study where they sent out basically people as subjects would go to financial advisors. About a quarter of them had a very proper, well diversified portfolio of index funds. The vast majority of the financial advisors said, I don’t know, let’s sell all these and let’s put you into some high price actively managed funds.
William Bernstein: Exactly. Never mind the capital gains you’d incur by doing that either.
Robert Brokamp: In the book you provide some excellent model portfolio, some very detailed lists of mutual funds, index funds, ETFs. People should consider so highly, recommend people read the book to get some more specific ideas on how to manage your portfolio. But let me talk just about some general stuff that you wrote about. Tell us about what you call the treasury bill theory of equanimity.
William Bernstein: Well, that gets to what I was talking about earlier about how you behave in the worst 2% of the times determines whether your portfolio survives in the long term. You can reap the benefits of the magic of compounding.
Treasury bills have terribly low returns. But in the long run, they may well be the highest returning asset class in your portfolio, because they’re what enables you to sleep at night and for that matter, buy groceries when you may lose your job during the worst of times. The way I like to summarize that is there’s a reason why Warren Buffet holds 20% of the assets of Berkshire in treasury bills or cash equivalents for just that reason. It’s also how the rich get richer, if you have enough safe assets, if you have enough treasury bills to live on for three years, or five years, or better yet, a decade. You’re not going to panic when the rest of your holdings, the risky assets and stocks that you own, fall by 50 or 60%, you’re not going to pull the trigger and sell those at the bottom. That is basically how the rich get richer. The rich have enough safe assets to sleep through the bad times so that the risky assets can grow to the sky.
Robert Brokamp: In the book, you talk about tilting your portfolio toward things like small caps, international stocks, and value. Let’s just focus on value. All three of those have actually lagged, generally speaking, over the last decade or so. In some cases longer. What’s your take on why growth has outperformed value? In your opinion, should people be tilting more toward value now that they look at least relatively cheaper?
William Bernstein: Yeah. The best real question is, why has value lagged over the past 20 or 30 years? There’s two possible explanations. One is that everybody now knows about the value effect, the value premium, so they’ve piled into that arbitrage away the advantage. They’ve raised the relative prices of value stocks to the point where they no longer beat growth, in fact, lag behind it. That’s the first possible explanation. The second possible explanation is that they’ve just fallen out of fashion. In which case they will have gotten cheaper relative to growth stocks, even more cheap than they normally are. All of the data that I’ve seen points to that last explanation, that value stocks in fact have gotten relatively cheaper and should offer higher returns going forward. That’s not offered with a minus muffler guarantee. Most good things in finance are at best at 55, 45 bet, so I wouldn’t bet the firm on that one. But it’s something that if I had to bet one way or the other, I would bet on value stocks, and not with my entire portfolio as well. I would still own some growth stocks or at least the total stock market. But the second part of this is what we’re talking about is true only in the US. If you look at foreign stocks and you look at emerging market stocks, over the past, whatever long period you want to look at five years, 10 years, 20 years, 30 years, value stocks and small stocks have outperformed.
Robert Brokamp: Just a couple of more questions here. Your book is mostly about investing, but you do touch on retirement planning every once in a while. In this area, there’s one clear piece of advice that you have. People should delay Social Security to age 70.
William Bernstein: Absolutely. The only reason to not do that is if both you and your spouse are in poor health, or if you’re unmarried and you’re in poor health. Of course, if you’re absolutely. I mean if you’re going to wind up living under a bridge, because you couldn’t take Social Security at 62, so take it at 62 if you absolutely have to. But the actuarial assumptions that increased Social Security benefit you get from age 70 is based on actuarial data, which is way out of date, and if Social Security ever gets around to fixing that, it’s not that advantage will not be as great. Take it, grab it while you can still grab it.
Robert Brokamp: The benefit is for every year you delay to 70, the benefit increases around 8% it’s inflation adjusted, and it’s also at least partially tax free. It is an outstanding way to building a bit of inflation protection and longevity protection into your portfolio.
William Bernstein: Absolutely. There is no better deal in terms of retirement planning than delaying Social Security to age 70. This is something that gets forgotten when people talk about things like annuities. Don’t even think about buying an annuity until you’ve paid up out of your retirement account to make it to age 70.
Robert Brokamp: Our final question, and it’s not a topic covered in your book, but for most people, in order to invest in safe retirement, they first need a job. These days we’re hearing an awful lot about how artificial intelligence is going to displace millions of workers. Now, given your neurology background, you know a thing or two about how the brain works, plus for what it’s worth. Besides your MD, you have a PhD in Chemistry, and just to impress our listeners, you also know how to fly a plane. I figure you have an opinion about how much AI will be able to replace future workers, be the doctors, pilots, technicians, authors, or whomever. Are you at all concerned? Are you worried about the future of maybe your children and your grandchildren, and their ability to earn a living?
William Bernstein: It’s hard not to worry about that. But I don’t worry about it as much as most people do because we’ve seen this movie before. Where you told 60 years ago that all of the bank tellers work would be done by ATM machines and that there wouldn’t be a such thing as telephone operators. You know, in the year 2023, you’d have thought, oh my God, we’re going to have a horrible unemployment problem. In fact, people have made this prediction over and over again that this technology or that technology is going to destroy all of these jobs. What always happens is that other jobs and better jobs and more jobs get created. It’s the same as the other prediction, which turns out to be chronically wrong, which is that we’re running out of natural resources. We’ve been running out of oil ever since Drake discovered oil in Western Pennsylvania 150 years ago. People have been predicting that on a reliable basis. It now appears more likely than not that we’re going to wind up keeping a lot of our oil reserves buried in the ground forever. I think that’s a possibility. Maybe it is different this time, but usually it isn’t different this time.
Robert Brokamp: Well Bill, as expected, this has been a fascinating discussion. Thanks so much for joining us.
William Bernstein: Pleasure is all mine.
Mary Long: As always, people on the program may have interest in the stocks they talk about. The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Mary Long. Thanks for listening. See you tomorrow fools.
Mary Long has no position in any of the stocks mentioned. Robert Brokamp, CFP(R) has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.